As oil passes $100, the question: will it stop?

If the global economy slows, oil prices will fall. But probably not until after March.

January 4, 2008

More gas, please: A worker stands near the Camilo Cienfuegos oil refinery inCuba. It was refurbished by Venezuela's state oil company PDVSA in a jointventure with Cuba and brought back into production in December. [: .]

Claudia Daut/REuters

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Oil futures hit a record $100 a barrel in futures trading this week, after attacks in Nigeria, Africa's leading oil producer. But most analysts expect that prices will decline from the current spike. A Reuters poll of 37 energy analysts' expectations yielded an average prediction of $74 a barrel for this year, compared with about $70 a barrel this past year.

If the global economy slows as expected, that will reduce demand for oil. But analysts warn that given the cold winter in the Northern Hemisphere, prices won't decline substantially until March. If the consensus is correct, that should mean steep declines in the last half of 2008. To get an average of $74 per barrel, current prices will need to fall to about $60. There are some dissenters. The investment firm Goldman Sachs, which correctly predicted $100 a barrel, recently raised its average price estimate for 2008 to $95 a barrel, reports staff writer Dan Murphy.

Basic economics and politics will determine the direction of prices. On the economic side, many economists are expecting global growth to slow and that would reduce demand for oil. But if the US and European economies continue to chug along, and China and India appear set to post double-digit growth rates again, those could be signals that prices will remain high.

On the political front, events like a war with Iran, a major deterioration in Iraqi security, or even greater instability in Nigeria, could drive up prices if oil traders worry that unrest threatens oil production or shipments.

Why might oil prices go down?

There is a small number of economists who argue that the 2007 surge in oil prices has had more to do with an overestimation of the risks of political chaos in oil producers and outright speculation than with the basics of supply and demand. Fadel Gheit, a senior official at Oppenheimer & Co. in New York who tracks the oil market, says he thinks prices are about $40 higher than the basics of supply and demand would indicate. But he's reluctant to predict when those declines will happen.

"I've been in this business for 20 years and what I'll tell you is only fools predict oil prices," he says. "But it's very clear in my mind that oil prices have been totally disconnected from reality and are not reflective at all of supply and demand fundamentals."

He points out that oil traders were justifying the surge in oil prices for much of 2007 because of fears of a possible US war with Iran. But since a US National Intelligence Estimate was released that made a war much less likely, oil prices have remained near record highs. "The NIE comes out and what happened? Nothing.... The premium that went into oil prices never left. The speculative market is like the tail wagging the dog."

"Now the market is saying prices have surged because of unrest in Nigeria? There's been unrest in Nigeria for 40 years, so who are they kidding?"

Aren't the Saudis boosting output to lower prices? Is manipulating the spigot still an option in a world where China and India are demanding much more fossil fuel?

The short answer to the first question is no. While Saudi Arabia is adding new production capacity, it, along with the rest of OPEC, declined to boost its output quotas in December, precisely because of expressed worries about a slowing economy. In theory, the Saudi government has 2 million barrels a day of spare capacity – equal to the International Energy Agency's prediction of demand growth in 2008 – but the country has not yet committed to releasing more of this to the market.

Over the next five years OPEC's members are hoping to add another 12 million barrels a day of capacity. But whether that will keep pace with the rising demand from India and China, is hard to gauge. Mr. Gheit says OPEC production increases aren't needed for prices to come down. "The market is adequately supplied. It will come down.... There have been and always will be commodity cycles."

Not for a long time, according to estimates by the UN and economists who track energy trends. The problem is that none of the alternatives like wind power and solar energy can yet meet anything near the energy demands of a growing world, and they remain more expensive than both oil and coal.

For instance, US Department of Energy statistics estimate that only 6 percent of US energy consumption now comes from renewable sources. A recent report from the International Energy Agency estimates that global energy demand will rise by 50 percent in the next two decades, driven by the Chinese and Indian economies, and that fossil fuels will provide 84 percent of this. Technological breakthroughs could change this picture, but none are yet on the horizon.

If oil goes to $200, what does that mean for US gasoline prices (i.e., how closely tied are US gasoline prices to oil prices)?

US gasoline prices have held fairly steady since the middle of the year, at about $3 a gallon, even as crude oil prices have marched higher, but ultimately the price of crude is the most important determinant in the price of gasoline. A general rule of thumb for gas prices is that for each $1 that's added to the price of crude, gasoline prices will rise about 2.5 cents per gallon. So if the price of crude rose to $200, from $100 today, average gasoline prices in the US would rise from about $3 to about $5.50 a gallon.